The risks and costs of exotic investments

‘Alternative’ products can be pricey for retirement savers

Private-equity mutual funds. Leveraged ETFs. Managed-futures funds. A growing number of investment products like these employ so-called alternative strategies, holding out the promise of diversification for investors who haven’t forgotten the pain of the 2008-09 stock- market downturn.

But given the risks and often steep costs of alternative investments—as well as levels of complexity that one investing expert compares to brain surgery—some financial pros say that investors are better served by a traditional stock-and-bond portfolio made up of low-cost index funds. After all, if you’re looking to protect your portfolio from the stock-market’s vagaries, don’t forget that long-term U.S. government bonds were among the best-performing asset classes in 2008.

There’s no doubt that alternatives can pay, and pay big—and they certainly have done so for the university endowment that popularized them. The idea of boosting a portfolio’s growth and hedging against risks by investing in private equity, real estate (that is, actual properties), hedge funds and other alternatives was made famous in recent years by David Swensen, manager of the Yale University endowment, who has published two books that discuss the approach that’s now known as the “Yale Model.” (Swensen has also said that the approach isn’t right for everybody: In the book “Unconventional Success,” he argues that individual investors are best served by index mutual funds.)

The $19.3 billion Yale fund enjoyed a gain of almost 11% annually in the 10 years ending June 30, 2012. It gained about 5% in the 12 months ending June 30, 2012, the fund’s most recently reported performance period; the Standard & Poor’s 500-stock index gained just over 3% during that span. Read Yale’s most recent report here.

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An increasing number of mutual funds and ETFs aim to make the same and other esoteric investing strategies available to all investors.

For example, the first managed-futures mutual fund launched in 2009—now there are 50 such funds, according to research firm Morningstar. Generally, with these funds, investment professionals employ a discretionary strategy for going long or short on a variety of futures contracts. (Here’s Morningstar’s guide to how they work.)

And, as of the end of 2012, investors had plowed $318 billion into some 365 commodity-related mutual funds and ETFs, up from 61 such funds holding $10 billion in assets a decade earlier, according to Morningstar.

Some advisers embrace alternatives

A majority of money managers say they hope to mimic the Yale Model’s success—or at least better diversify and protect their clients’ portfolios. In a 2012 survey of 1,741 financial advisers with at least $5 million in assets under management, by Cogent Research, a financial-services market-research firm, 74% said they use alternative products or strategies.

Forty-seven % of the advisers said they employed alternative strategies to add diversification, while 25% said their objective was downside protection.

“Until recently, the average investor did not have access to these other types of asset classes,” said Scott Cramer, president of Cramer & Rauchegger, a financial planning firm in Maitland, Fla. Mimicking the university-endowment model, he said, is a way to “enhance your returns, get you the income you need, reduce your volatility and keep you out of trouble in bad times.”

The catch? Getting it right requires time and research, and that will cost you more than any index mutual fund. Plus, for some alternative products—private offerings, for example, or mutual funds that have large investment minimums—you’ll need to find a financial adviser whom you trust to understand the complexities.

For example, Cramer said he has invested in nontraded REITs, which aren’t bought and sold on public stock exchanges, for a portion of his clients’ portfolios. That entails a comprehensive vetting process, he said, including evaluating the REIT’s business models and meeting with management.

Doing it yourself—for a price

There are ways to go it alone via mutual funds that employ alternative products or strategies. But you’ll pay more. The typical range of net expense ratios for alternative mutual funds is 1.5% to 2.2%, or $150 to $220 per $10,000 invested, according to Morningstar. By comparison, the average expense ratio on a Vanguard index fund is about 0.15%, or $15 per $10,000.

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